The Supreme Court of Appeal (SCA) recently ruled in CM v EM [2020] 3 All SA 1 (SCA) that the value of a living annuity falls in the policyholder’s estate on divorce or death. In this case, the couple were married out of community of property with accrual and the contention was whether Mr EM’s living annuity – purchased prior to filing for divorce – should be included in determining the accrual. The court found that although the assets underlying the policy were owned by the life insurance company, Mr EM had the right to draw an income from those assets, and that the income stream should be valued as part of his estate. The ruling closed the loophole whereby an individual could move assets from their estate into a living annuity at the expense of their spouse.

The calculation

However, the question as to how exactly the living annuity is to be valued was not answered by the court. There is common actuarial agreement on the basis of the calculation, namely –

• projecting the income into the future;
• applying income tax and mortality; and
• then discounting it to the present.

The difficulty, however, is that the policyholder can choose what level of income to draw from the pool of assets, and can change that on a yearly basis, varying between 2,5% to 17,5% (the ‘drawdown rate’) of the underlying asset value.

It should also be noted that a policyholder will (in theory) never completely exhaust the underlying assets as one can only ever draw a percentage of the underlying assets. This risk to the policyholder is to draw too much early on and thereby deplete the policy to such an extent that they have insufficient income in their old age. Nothing prohibits a policyholder, however, to draw down at a high percentage and reinvest part of the proceeds to provide income later in life. A further important consideration is that the policyholder can never access the underlying assets, which will only be paid to nominated beneficiaries or their estate upon their death. As such, only the income drawn from the living annuity and other assets they own can be used to meet any financial obligations to their spouse.

The assumed drawdown rate

An obvious starting point would be to value the income stream at the level of drawdown effective at the time of divorce. However, that still leaves a loophole whereby a policyholder can lower their drawdown percentage in anticipation of the divorce, and thus prejudice their spouse.

The choice of reasonable drawdown rate is riddled with individual and subjective factors. One should consider the following scenarios:

• The drawdown percentage at the time of divorce

On the assumption that this level of drawdown is representative of what the policyholder would have drawn regardless of the divorce (rarely less than 6%), the valuation of the income stream at this level gives a useful indication of the ‘lower end’ of the living annuity’s value. This is because the real (inflation-adjusted) Rand value of yearly income, at a fixed drawdown percentage, will most likely be eroded over time, and hence this scenario is based on a level of income that is likely to be insufficient in the long run.

• Drawdown increasing annually at consumer price index (CPI) inflation

A more reasonable scenario may be to assume that the policyholder will increase the Rand amount drawn each year in line with CPI inflation. This is a good ‘middle of the road’ basis on which to value the living annuity.

• Taking the maximum drawdown

A useful theoretical calculation is to assume the maximum drawdown rate. This represents the maximum income the policyholder can get from the living annuity and anything less is by choice. If the policyholder had to re-purchase the right to the income stream for oneself, one could argue that this value would be the correct price since it represents the value the buyer can obtain.

In reality, the considerations are more complex, and most people will draw less than the maximum to mitigate longevity risk.

The value of the living annuity

The above three scenarios give a range of possible values of the living annuity. There is, however, not an objectively correct value (due to the unknown future draw down rates), and the value determined should take into account further considerations such as:

• The extent to which the values of the methods above differ. If these values are relatively close to each other, one should have a high degree of confidence that any number within the range reasonably represents the true underlying value and parties can agree on, for instance, the average value.
• If, however, the range of values is more spread out, one would have to place more emphasis on method three above – this will be more prevalent in cases with a low drawdown rate. For instance, if the different methods yield values of R 1 million, R 1,3 million and R 3 million, it does not seem fair to give equal weight to the lower numbers as they are, after all, low due to the policyholder’s choice of drawdown rate. It may be appropriate to weight the value more towards that of method three, subject to the next two points.
• The policyholder and spouse’s overall financial position and needs – this will affect their reliance of the living annuity to meet their basic needs, their income tax rate and their current drawdown rate.
• The policyholder’s liquidity – if the living annuity is their only source of income, they might have to borrow at punitive rates to pay their spouse’s share and hence a value lower on the scale will be appropriate.

Willem Boshoff is a senior actuary and SAMLA registered Medico-Legal practitioner at Munro Forensic Actuaries in Cape Town.

This article was first published in De Rebus in 2021 (March) DR 40.